HOW INCOMES ARE DETERMINED
Demand and Supply
in Factor Markets
PART 6
CHAPTER
18
CHAPTER CHECKLIST
When you have completed your study of this
chapter, you will be able to
1
2
3
4
5
Describe the anatomy of the markets for labor,
capital, and land.
Explain how the value of marginal product
determines the demand for a factor of production.
Explain how wage rates and employment are
determined.
Explain how interest rates, borrowing, and lending
are determined.
Explain how rents and natural resource prices are
determined.
18.1 THE ANATOMY OF FACTOR MARKETS
The four factors of production that produce goods and
services are:
•
•
•
•
Labor
Capital
Land
Entrepreneurship
18.1 THE ANATOMY OF FACTOR MARKETS
Factor price
The price of a factor of production.
• The wage rate is the price of labor.
• The interest rate is the price of capital.
• Rent is the price of land.
Factor market
A market for labor, capital, or land.
18.1 THE ANATOMY OF FACTOR MARKETS
 Labor Markets
Labor market
A collection of people and firms who are trading labor
services.
Job
A contract between a firm and a household to provide
labor services.
18.1 THE ANATOMY OF FACTOR MARKETS
 Financial Markets
Capital
The tools, instruments, machines, and other
constructions that have been produced in the past and
that businesses use to produce goods and services.
Financial capital
The funds that firms use to buy and operate physical
capital.
18.1 THE ANATOMY OF FACTOR MARKETS
Financial Market
A collection of people and firms who are lending and
borrowing to finance the purchase of physical capital.
The two main types of financial market are
• Stock market
• Bond market
18.1 THE ANATOMY OF FACTOR MARKETS
Stock Market
A stock market is a market in which the shares in the
stocks of companies are traded.
Examples: the New York Stock Exchange, NASDAQ.
18.1 THE ANATOMY OF FACTOR MARKETS
Bond Market
A bond market is a market in which bonds issued by
firms or governments are traded.
Bond
A promise to pay specified sums of money on specified
dates.
18.1 THE ANATOMY OF FACTOR MARKETS
Land Markets
Land consists of all the gifts of nature.
A market in which raw materials are traded are called a
commodity market.
Competitive Factor Markets
Most factor markets have many buyers and sellers and
are competitive markets.
18.2 DEMAND FOR A FACTOR OF PRODUCTION
Derived demand
The demand for a factor of production, which is derived
from the demand for the goods and services it is used
to produce.
Value of marginal product
The value to a firm of hiring one more unit of a factor of
production, which equals price of a unit of output
multiplied by the marginal product of the factor of
production.
18.2 DEMAND FOR A FACTOR OF PRODUCTION
Value of Marginal Product
Table 18.1 on the next slide walks you through the
calculation of the value of marginal product.
18.2 DEMAND FOR A FACTOR OF PRODUCTION
The first two columns of
the table are the firm’s
total product schedule.
To calculate marginal
product, find the
change in total product
as the quantity of labor
increases by 1 worker.
18.2 DEMAND FOR A FACTOR OF PRODUCTION
To calculate the value
of marginal product,
multiply the marginal
product numbers by
the price of a car
wash, which in this
example is $3.
18.2 DEMAND FOR A FACTOR OF PRODUCTION
18.2 DEMAND FOR A FACTOR OF PRODUCTION
Figure 18.1
shows the value
of the marginal
product at Max’s
Wash ’n’ Wax.
The blue bars
show the value
of the marginal
product of the
labor that Max
hires based on
the numbers in
the table.
18.2 DEMAND FOR A FACTOR OF PRODUCTION
The orange line
is the firm’s
value of the
marginal
product of labor
curve.
18.2 DEMAND FOR A FACTOR OF PRODUCTION
A Firm’s Demand for Labor
A firm hires labor up to the point at which the value of
marginal product equals the wage rate.
If the value of marginal product of labor exceeds the
wage rate, a firm can increase its profit by employing
one more worker.
If the wage rate exceeds the value of marginal product
of labor, a firm can increase its profit by employing one
fewer worker.
18.2 DEMAND FOR A FACTOR OF PRODUCTION
A Firm’s Demand for Labor Curve
A firm’s demand for labor curve is also its value of
marginal product curve.
If the wage rate falls, a firm hires more workers.
18.2 DEMAND FOR A FACTOR OF PRODUCTION
Figure 18.2 shows the demand
for labor at Max’s Wash’n’ Wax.
At a wage rate of $10.50 an
hour, Max makes a profit on the
first 2 workers but would incur a
loss on the third worker.
18.2 DEMAND FOR A FACTOR OF PRODUCTION
Figure 18.2 shows the demand
for labor at Max’s Wash’n’ Wax.
At a wage rate of $10.50 an
hour, Max makes a profit on the
first 2 workers but would incur a
loss on the third worker.
So Max’s quantity of labor
demanded is 2 workers.
Max’s demand for labor curve is
the same as the value of
marginal product curve.
18.2 DEMAND FOR A FACTOR OF PRODUCTION
The demand for labor curve
slopes downward because the
value of the marginal product of
labor diminishes as the quantity
of labor employed increases.
18.2 DEMAND FOR A FACTOR OF PRODUCTION
Changes in the Demand for Labor
The demand for labor depends on:
• The price of the firm’s output
• The prices of other factors of production
• Technology
18.2 DEMAND FOR A FACTOR OF PRODUCTION
The Price of the Firm’s Output
The higher the price of a firm’s output, the greater is its
demand for labor.
The Prices of Other Factors of Production
If the price of using capital decreases relative to the
wage rate, a firm substitutes capital for labor and
increases the quantity of capital it uses.
Usually, the demand for labor will decrease when the
price of using capital falls.
18.2 DEMAND IN FACTOR MARKET
Technology
New technologies decrease the demand for some types
of labor and increase the demand for other types.
18.3 WAGES AND EMPLOYMENT
The Supply of Labor
People supply labor to earn an income. Many factors
influence the quantity of labor that a person plans to
provide, but the wage rate is a key factor.
Figure 18.3 on the next slide shows an individual’s labor
supply curve.
18.3 WAGES AND EMPLOYMENT
The table
shows Larry’s
labor supply
schedule,
which is
plotted in the
figure as
Larry’s labor
supply curve.
18.3 WAGES AND EMPLOYMENT
1. At a wage
rate of
$10.50 an
hour, Larry
…
2. …supplies
30 hours of
labor a week.
18.3 WAGES AND EMPLOYMENT
3. As the wage
rate rises,
Larry’s
quantity of
labor
supplied …
4. …increases,
5. …reaches a
maximum,
…
6. …then
decreases.
18.3 WAGES AND EMPLOYMENT
Larry’s labor
supply curve
eventually
bends
backward.
18.3 WAGES AND EMPLOYMENT
Market Supply Curve
A market supply curve shows the quantity of labor
supplied by all households in a particular job.
It is found by adding together the quantities of labor
supplied by all households at each wage rate.
Figure 18.4 on the next slide shows the supply of car
wash workers.
18.3 WAGES AND EMPLOYMENT
This supply
curve shows
how the
quantity of car
wash workers
supplied
changes when
the wage rate
changes, other
things
remaining the
same.
18.3 WAGES AND EMPLOYMENT
In a market for
a specific type
of labor, the
quantity
supplied
increases as
the wage rate
increases, other
things
remaining the
same.
18.3 WAGES AND EMPLOYMENT
 Influences on the Supply of Labor
Three key factors influence the supply of labor:
• Adult population
• Preferences
• Time in school and training
18.3 WAGES AND EMPLOYMENT
Adult Population
An increase in the adult population increases the supply
of labor.
Preferences
There has been a large increase in the supply of female
labor since 1960.
The percentage of men with jobs has shrunk slightly.
18.3 WAGES AND EMPLOYMENT
Time in School and Training
The more people who remain in school for full-time
education and training, the smaller is the supply of lowskilled labor.
18.3 WAGES AND EMPLOYMENT
Labor Market Equilibrium
Labor market equilibrium determines the wage rate and
employment.
Figure 18.5 on the next slide illustrates equilibrium in
the market for car wash workers.
18.3 WAGES AND EMPLOYMENT
1. The equilibrium wage
rate is $10.50 an hour.
2. The equilibrium quantity
of labor is 300 workers.
18.3 WAGES AND EMPLOYMENT
If the wage rate exceeds
$10.50 an hour, the
quantity demanded is less
than the quantity supplied
and the wage rate falls.
If the wage rate is below
$10.50 an hour, the
quantity demanded
exceeds the quantity
supplied and the wage rate
rises.
18.4 FINANCIAL MARKETS
 The Demand for Financial Capital
A firm’s demand for financial capital stems from its
demand for physical capital to produce goods and
services.
The quantity of physical capital that a firm plans to use
depends on the price of financial capital—the interest
rate.
Two factors that change the demand for captial are:
• Population growth
• Technological change
18.4 FINANCIAL MARKETS
 The Supply of Financial Capital
The quantity of financial capital supplied results from
people’s saving decisions.
The higher the interest rate, the greater is the quantity
of saving supplied.
The main influences on the supply of saving are:
• Population
• Average income
• Expected future income
18.4 FINANCIAL MARKETS
Financial Market Equilibrium and the Interest
Rate
Financial market equilibrium occurs when the interest
rate has adjusted to make the quantity of capital
demanded equal the quantity of capital supplied.
Figure 18.6 on the next slide illustrates financial market
equilibrium.
18.4 FINANCIAL MARKETS
The demand for financial
capital is KD, and the
supply of financial capital is
KS.
1. The equilibrium interest
rate is 6 percent a year.
2. The equilibrium quantity
of financial capital is
$200 billion.
18.5 LAND AND NATURAL RESOURCE MARKETS
All natural resources are called land, and they fall into
two categories:
• Renewable
• Nonrenewable
Renewable natural resources
Natural resources that can be used repeatedly.
Nonrenewable natural resources
Natural resources that can be used only once and that
cannot be replaced once they have been used.
18.5 LAND AND NATURAL RESOURCE MARKETS
The Market for Land (Renewable Natural
Resources)
The lower the rent, the greater is the quantity of land
demanded.
The supply of a particular block of land is perfectly
inelastic.
Figure 18.7 illustrates this market for land.
18.5 LAND AND NATURAL RESOURCE MARKETS
The demand curve for a 10acre block of land is D, and
the supply curve is S.
Equilibrium occurs at a rent
of $1,000 an acre per day.
18.5 LAND AND NATURAL RESOURCE MARKETS
Economic Rent and Opportunity Cost
Economic rent
The income received by any factor of production over
and above the amount required to induce a given
quantity of the factor to be supplied.
The income that is required to induce the supply of a
given quantity of a factor of production is its opportunity
cost—the value of the factor of production in its next
best use.
18.5 LAND AND NATURAL RESOURCE MARKETS
Figure 18.8 shows how the
income of a factor of
production divides between
economic rent and
opportunity cost.
1. Part of the income is
opportunity cost (the red
area).
2. Part is economic rent
(the green area).
18.5 LAND AND NATURAL RESOURCE MARKETS
The Supply of a Nonrenewable Resource
Over time, the quantity of a nonrenewable resource
decreases as it is used up.
But the known quantity of a natural resource increases
because advances in technology enable ever less
accessible sources of the resource to be discovered.
Using a natural resource decreases its supply, which
causes price to rise.
New discoveries increase supply, which cause prices to
fall.
Factor Markets in YOUR Life
Would you like to be a millionaire?
If so, it is in factor markets that you are going to make it
happen.
You might come up with a $1 million idea—borrow to
finance capital expenditure and hire labor.
But the surest way is by saving.
If, starting at age 25, you save $66 a week and earn
interest at 8 percent a year, how will it take to accumulate
$1 million?
40 years! You’ll be a millionaire at age 65.
By making the capital market work for you, you can grow a
few dollars a week into $1 million.